China’s Internet: The Invisible Birdcage

This essay I wrote last year originally appeared in the September 2010 issue of the China Economic Quarterly. Some of the numbers may already be a bit dated but it is still relevant. The editor chose the title; all errors are my responsibility.

“China internet adds 12th website” – The Onion (July, 2009)

The Onion’s satirical headline reflects a common foreign perception – reinforced when Google pulled out of its China business in early 2010 – that China’s internet is a suffocated tool of the state. That idea is mistaken. Censorship of certain subjects is pervasive, but the internet in China is thriving: over 400m Chinese regularly go online, private-sector internet companies generate billions of dollars in annual revenue, and the 30 or so listed Chinese firms have a combined market capitalization approaching US$100 bn. Although the state’s grip is tightening, the vast majority of Chinese websites remain relatively free of state interference. The Onion ignores the fact that three of the top six global internet businesses are Chinese.

This vibrant social space has distinctive characteristics. The amazing popularity of online gaming – uniquely, in China, more lucrative than advertising – attests to netizens’ focus on entertainment. Instant messaging, online chat sites and bulletin boards, moreover, are far more widely used than email. But in other respects China’s netizens resemble their counterparts in the West. They read news, download music and watch movies (many of them pirated). Social networking sites are growing in popularity, and the popularity of Twitter-like microblogs exploded over the past year. Indeed, the internet has created an unprecedented space for civil discourse in China: netizens use bulletin boards, instant messaging (especially Tencent’s QQ service), social networking sites, blogs and microblogs to share information, gripe, expose corruption, and otherwise carry on a robust and growing online conversation.

Inevitably, the growing economic and social clout of the internet has made it a target of greater government regulation. Until 2007, the regulatory environment was actually rather lax, which created space for nimble, private startups to dominate the emerging industry. But Beijing is beginning to assert its regulatory grip: the State Council published a white paper in June outlining detailed plans for governing the internet’s development, and the number of foreign social networking websites blocked by the “Great Firewall” grew over the past three years. The internet is now heavily regulated, although self-censorship remains the chief means of controlling content. Private players remain on top, but cashed-up state-owned media enterprises such as CCTV have aggressive expansion plans and hope to knock private competitors off their perch.

Game Theory

The Chinese internet’s revenue structure is quite different from that of the US and other Western countries, which are dominated by advertising. At over US$4 bn, China’s online gaming revenues are larger than those of the US. Tens of millions of Chinese online gamers play a wide variety of games, from solitary card games to multiplayer role-playing games and shoot ’em ups. The boom in online gaming has created several US-listed, billion-dollar companies, including Shanda Games, Giant Interactive, Perfect World, Changyou and Netease. Tencent, China’s largest internet company and the third largest internet company in the world by market capitalization, derives a large chunk of its profits from online gaming. When the industry started in 1999-2000, complex multiplayer games were all imported, but a series of government development programs helped domestic gaming companies to grab the lion’s share of revenues. Strict regulations explicitly protect domestic champions from competition, and foreign gaming firms cannot sell their products in China without a local Chinese partner. Beijing recently put in place export incentives for Chinese game firms, while reaffirming the restrictions on foreign games.

Crucially, online gaming is responsible for creating a viable online payments system in a country with very low credit-card penetration and almost no concept of recurring subscription charges. Most games offer at least a half dozen payment channels, including top-up cards, debit cards, credit cards and Paypal-type online payment services, notably Alibaba’s Alipay and Tencent’s Tenpay. Typically for the sector, the government allowed private companies to develop these services over several years before introducing a detailed regulatory regime, which will take effect from September 1. State-owned players are now eying the potentially lucrative online payments market, with China Mobile’s recent investment in Shanghai Pudong Development Bank widely viewed as a strategic investment to accelerate its mobile payments service.

The biggest winner from the growth of online payments is ecommerce, led by Alibaba Group’s business-to-business (B2B) service Alibaba.com and its consumer site Taobao. Ecommerce trade volume surpassed US$530 bn in 2009, according to official figures, and is on course to surpass the US within five years. Taobao, which destroyed eBay’s business on its way to becoming the country’s dominant internet retail platform, relies on advertisers for most of its income. According to official government statistics, advertisers spent US$3 bn online in 2009, and that figure is projected to grow over 30% per year. Compared, however, to the advertising market in China for television, newspapers and magazines – which measured US$88 bn in 2009, according to market research company Nielsen – the online ad market is still disproportionately small. China’s online advertising revenues are only around 15% of ad revenues in the US, and there is considerable potential for growth.

Digital Triumvirate

The success of homegrown internet names such as Taobao and Baidu at the expense of global giants like Ebay and Google is responsible for a popular misconception that foreigners are shut out of China’s foreign internet market. This may be true of wholly-owned foreign operating firms, but foreign investors have poured billions of dollars into Chinese internet firms. China’s big three – Tencent, Baidu and Alibaba – are entrepreneur-founded, foreign venture-capital-backed, overseas-listed firms. South African multimedia company Naspers owns approximately 35% of Tencent, while Yahoo and Japan’s Softbank own a majority of Alibaba Group. Google was a pre-IPO investor in Baidu before it exited with a handsome profit. Almost all of China’s major internet firms are classified as foreign-invested entities, which in theory means they are subject to the same restrictions as Yahoo, Google or any other foreign firm. Most foreign internet companies have failed in China because they were unable to compete effectively against very talented local competition, not because they were shut out of the market.

Over the past few years, however, Beijing’s decision to increase its controls over internet content hit a handful of high-profile foreign internet businesses targeting the Chinese market. The change occurred in 2008, possibly triggered by Beijing’s paranoid preparations for the Olympics and unfavorable foreign coverage of the riots in Tibet, when websites such as Facebook and Youtube were first blocked. Since then, the government has taken a much more aggressive regulatory role, declaring certain sectors like online video off limits to new investment by non-state-owned entrants, and launching a proactive campaign to guide public opinion online. June’s white paper states that the internet must serve the interests of both the economy and the state.

So far, private domestic players have not suffered. But with the Party-state’s propaganda machine and billions of dollars at stake, government media outlets are beefing up their online presence. CCTV, the state-owned television broadcaster, has launched an online TV service that may eventually threaten the more established online video sites like Youku and Tudou, which have tens of millions of viewers every month. People’s Daily, the Party-controlled newspaper, recently restructured its online division into a new company, which is planning to list on the Shanghai stock exchange before the end of 2010. People’s Daily Online has also launched a search engine – Goso.cn – that aspires to compete with the likes of Baidu. Nine other state-owned media firms have been approved to list their online arms on the Chinese stock market.

Whether these state media enterprises can attract a critical mass of users is uncertain, but China’s propagandists are determined to give state-run media outlets a greater role in shaping online debate. Writing in the Party journal Seeking Truth in December 2009, Meng Jianzhu, the Minister of Public Security, wrote: “The internet has become a primary method for the anti-China forces to infiltrate us and amplify destructive energy. This provides new challenges in maintaining state security and social stability.” Censorship of foreign content has shifted from news sites to Web 2.0 services with superior communication and organizing functions, such as Twitter and Facebook, which the government accuses of becoming a rallying point for dissidents and separatists. A report on new media published by the Chinese Academy of Social Sciences in July bluntly states: “Foreign social networking sites have become a tool for political subversion used by Western nations.”

Control 2.0

Tech-savvy netizens can easily sidestep the Great Firewall with VPNs, proxy servers and other special software. But most of China’s 400m plus internet users stay within filtered Chinese sites, partly for cultural and linguistic reasons, but also because circumventing the government’s controls is simply inconvenient. Chinese internet companies are forced to sign government-mandated “self discipline” pledges, and large firms employ dozens or hundreds of censors who monitor content and remove anything of concern. Failure to comply leads to warnings, fines, shutdowns or worse. The government provides guidance on restricted topics but has structured enough ambiguity into the system so that company censors frequently overcompensate in their efforts to comply. The rise of social networking sites – especially Twitter-like microblogs such as Sina’s Weibo, which has an estimated 20m users [approximately 100m at the time of this blog posting] – have dramatically increased the filtering tasks. Sina’s chief editor complains that policing Sina’s microblogs is “a very big headache.”

Rebecca MacKinnon, an expert on Chinese internet censorship, calls the government’s approach to information control “networked authoritarianism.” By allowing citizens enough freedom to draw attention to social problems or injustices, she argues, they become less likely to join a movement calling for radical political change. “In many ways,” McKinnon explains, “the regime actually uses the internet not only to extend its control but also to enhance its legitimacy.” Aside from being a societal pressure valve, the internet is a useful means for the central government to supervise wayward local officials. Indeed, June’s white paper explicitly states that the government “attaches great importance to the internet’s role in supervision.”

Beijing, in other words, has a political interest in keeping China’s internet commercially healthy. Observers who predicted a decade or more ago that China’s political and economic structures were unsustainable and the country would imminently “crash” were wrong. And contemporary analysts who believe that the relatively closed nature of China’s internet will lead to the downfall of the Party-state will likely be proved wrong, too. Chen Yun, a Party elder who spent much of his career overseeing the economy, advocated the idea of a “birdcage economy” for China. The cage was the state economic plan, within which free markets – the birds – could move freely. China’s approach to managing the internet is similar: the government has built a gilded cage around the internet that will prove far more robust than its critics expect.

For more frequent China-related updates you can follow me on Weibo @billbishop and on Twitter @niubi.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

Bill Bishop is an American living in Beijing. He is bilingual and has experience working in both US and China. In 1997 he co-founded CBS MarketWatch and stayed until the sale in 2004 to Dow Jones. He was never a journalist, and instead worked in several business roles over the years, the last as head of the MarketWatch consumer Internet business. More »

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